U.S. Treasury Runs Into Theories on Irrational Investing

The Treasury Department’s decision to shelve its plans to sell its stake in Citigroup Inc. struck us as a prime example of a popular theory in economics called ‘loss aversion’ at play in the real world with large stakes.

The Treasury abruptly shelved plans to reduce its 34% stake in Citigroup Inc. after investors balked at buying the bank’s shares. Given the tepid demand, Citigroup had to sell its stock at a discounted price of $3.15 a share. That’s 10 cents below what the Treasury paid for each of its 7.7 billion shares. Unwilling to take what would have been a politically embarrassing loss, the government backed away for at least 90 days.

Princeton University psychologist Daniel Kahneman has noted that individual investors have an irrational tendency to avoid selling their losing investments.

Say you have two traders. One buys a stock when it’s at $90 per share and another buys it when it’s at $110. If today the stock is at $100 per share, the person who bought at $90 is much more willing to sell than the person who bought at $110.

Mr. Kahneman’s insight helped to make a broader point –- individuals often act in emotional or irrational ways, counter to the view that individuals act purely out of self-interest. He won a Nobel prize in economics for the insight.

In the hypothetical case above, the fundamental value of the stock is no different for either investor. But the person who bought at a high price and faces a loss is so anchored to what he paid for it that he can’t make a decision based purely on today’s fundamentals. Guys on Wall Street also call this “cost trading.”

Here’s how Mr. Kahneman described it in an interview in 2007: “People in general don’t like cutting their losses. They’re willing to gamble on in the hope of recovering their losses, and that is a very well known characteristic of individual decision making, and in national decision making it’s exacerbated because the national leaders who have led the country close to defeat, for them there is really nothing further to be lost by putting more at risk. There is a real divergence of interest between national leaders and their communities when the time to cut losses arises, because cutting losses is rarely beneficial to the decision maker.”

It should be said that the Treasury has made money on many of its TARP investments, and the broader benefit to society of steering the financial system from collapse with TARP investments and other rescues was clearly large.

But when it comes to this particular Citi decision not to sell, Mr. Kahneman’s thoughts seem very apt. What will the government do in March if the shares have fallen even further?

About Real Time Economics

Real Time Economics offers exclusive news, analysis and commentary on the U.S. and global economy, central bank policy and economics. Send news items, comments and questions to the editors and reporters below or email realtimeeconomics@wsj.com.